M&A: Exelon and Pepco Closer to Consummating Their Union

Since Thomas A. Edison threw the first power switch over a century ago, none of the literally hundreds of mergers between regulated electric utilities have failed to produce a much stronger company. This industry rewards scale, to the benefit of customers and shareholders alike.

On the other hand, no other industry faces as much uncertainty when it comes to closing deals. CLECO Corp’s (NYSE: CNL) shareholders found that out the hard way this week. The stock plummeted by more than 12 percent since Monday after the Louisiana Public Service Commission put the kibosh on a US$3.4 billion takeover offer from an investor group led by Macquarie Infrastructure and Real Assets and British Columbia Investment Management Corp.

Shareholders of Pepco Holdings (NYSE: POM) appeared doomed to a similar fate this morning, when District of Columbia regulators rejected a proposed settlement to pave the way for its acquisition by Exelon Corp (NYSE: EXC). But the selloff in Pepco’s stock quickly reversed course when it became clear that two of the three commissioners on DC’s Public Service Commission were prepared to approve the union with some additional conditions.

In light of this development, Exelon is expected to agree to the new terms, setting the stage for the deal to close in the next several weeks. Accordingly, Pepco’s stock has inched closer to Exelon’s all-cash bid of $27.25 per share, while the takeover’s opponents have sounded their disappointment in the local media.

The additional conditions don’t appear to be onerous:

A delay in the allocation of $25.6 million in customer rate credits until Pepco’s next rate hearing;

The creation of a $32.8 million fund to upgrade DC’s power distribution system;

Additional efficiency and conservation guarantees;

Exelon’s withdrawal from a project to build a 5-megawatt solar-power facility to serve a DC water treatment plant; and

A review of the utility’s role in expanding microgrids.

The latter two conditions appear to be a concession to renewable-energy developers in DC, some of which had complained that competition from the utility would undercut their business. All told, these changes shouldn’t affect the deal’s long-term economics, and Exelon will benefit from an increase in the proportion of its revenue that come from regulated operations.

The key decider in this case was Commissioner Joanne Dotty Ford, who voted against the merger as proposed but for its approval with the new conditions. Commission Chair Betty Ann Kane voted against the companies’ proposal and the deal with conditions, while Commissioner Willie Phillips cast his vote in support of both proposals.

How the voting shook out could have important implications for the utility’s next rate case, but the acquisition looks likely to move forward.

A Solid Fourth Quarter

With all eyes on pending takeover of Pepco, investors largely ignored Exelon’s robust fourth-quarter results and encouraging guidance for 2016, which calls for the first dividend increase since the utility slashed its payout by 41 percent in February 2013.

Equally important, these annual dividend increases of 2.5 percent would have occurred over the next three years with or without the addition of Pepco’s assets, fueled by $18 billion worth of capital expenditures at Exelon’s regulated operations and efficiency gains at its fleet of unregulated nuclear power plants.

Exelon’s guidance also calls for earnings per share to range between $2.40 and $2.70 per share without a contribution from Pepco. And earnings from Exelon’s legacy assets could surprise to the upside if the company reaches deals in New York and Illinois to keep its smaller nuclear power plants running.

Pepco’s fate as an independent company wouldn’t be as sanguine. For one, the utility’s dividend coverage ratio has thinned considerably over the past two years because the company hadn’t filed for any rate increases since agreeing to Exelon’s takeover bid.

Exelon will have no problem shouldering this rate lag. But if Pepco were to remain independent, the company would have to file for rate increases in jurisdictions that were promised multiyear freezes related to the acquisition—creating the potential for disappointment, a lower share price and even a dividend cut.

We’ve rated Pepco Holdings a Sell in our Utility Report Card ever since the deal was announced, citing the potential for the acquisition to fall through or take a long time to win approval.

This rating stands. If you hold on and the deal closes as expected, you’ll net an additional $0.50 per share—still not worth the risk.

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